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29 December 2013

One Big Problem With Compounding & Why You Cannot Become A Long Term Investor!!

I have been
a hard-core follower of the concept of compounding.
And like Albert Einstein, I believe that it is the 8th wonder of the
world. Using this concept, you can make your money work for you rather than
working for it.

But there
is a problem with this concept. A big problem!

The problem
lies in the fact that this MAGIC of compounding does not begin during the first
few years. For example, you invest Rs 10,000 in a company’s shares, which is
capable of earning a realistic 10% every year. This would mean that next year,
a neat sum of Rs 1000 would be added to your original investment (assuming
linear returns for theoretical purposes). But now if this position grows to
almost Rs 1,00,000 after 15-20 years, because of dividend re-investments, compounding
etc, then going forward, a 10% return would mean Rs 10,000. This is not much.
But compared to what it produced in first year, it is almost 900% more. And that
is the problem with compounding. The money-making-magic begins after almost 15
years.

Compounding: Magic Begins After 15 Years

Similar is
the case with dividends. Annual dividends paid out by good dividend paying
companies after 15 years would be almost equal to what they produced in
first 10 years combined!! And that is one hell of money when you understand the
real meaning of the previous statement.

So if you
consider yourself to be a really long term investor who can stay focused for decades,
then you need to understand that real benefit of compounding begins only after
year 15. And frankly speaking, it is unlikely that Rs 10,000 investment is
going transform your life over a 15 year period of compounding. Rather, it is during
the next 15 years after that the magical wealth creation starts taking place.

And that is
why, we need to understand that one should accumulate as many shares as
possible, of few good,
stable and reliable companiesas core
holdings during the first 15 years of one’s investment career. Once
done, the magic begins to unfold after year 15. And believe me, with most of
your investments, the years 26-30 would produce much more wealth than the first
25 combined.

This shows why
most people are unable to keep faith in long term investing. Its simple but its
tough. And it requires a lot of patience from you. I personally aim to become a
long term investor. Currently I am in accumulation mode and prefer bear markets
to bull markets. (Evil Disclosure: I
continuously pray for market corrections) ;-)

What are your thoughts? Do you think its easy to wait for 15+ years to allow compounding to show its magic? Or do you think that its better to go for short term trading?

Problem with what you have written is that, one rarely is able to find a Company which can be hold on to for such a long time, the dynamics of free markets & capitalism ensures that no one should be able to compound capital for such a long time. Psychological implications of bear market & 60 - 80% price drop add excess pressure to long term vision. Its just that we are humans and act like one. We have to shuffle portfolio and get out or add companies and make mistake in this too:).

What you are saying about compounding is true 100%, but highly impractical to implement in real life finance.

I am sorry for the stupid comment Dev. No need to say that. I am a regular reader and like the blog very much. I feel it is one of the best blogs in terms of simplicity and unbiased-ness. I believe long term investing is dull, whereas activity is harmful. Keep up the good work. Happy new year to you and i wish Stable Investor all the very best for the coming 2014. I look forward for more such good posts from you.

Sure. Hence, an investor must be on his toes, by reading quaterlies and ARs. As soon as he is convinced that another opportunity has arisen, he must take it. So, that his graph of 10% growth each year, every year is on track.

10% is dismal. Debt funds offer that. One must aim for 18% atleast. After 8 odd years, one would be earning a good return. I have learned from Dev and few other sources and made a list of top-notch companies to invest in... I am all game... let the bears roll in.

Agreed to an extent. Investing for such long period is very (very) tough. And one can never be sure as to what might happen to a good company after 14 years of an investor's holding period. So its important to keep a hawkish eye on all developments related to company.

Thanks :-)But if you are a long term investor and have invested in good companies, doesnt it make more sense to stay with the company for longer durations rather than buying and selling? This would also save you money on transaction and brokerage costs.